Primary Market and Secondary Market – How do they work?
Stock markets are an important component of the financial system. It is a powerful tool that works like an auction for the exchange of capital/credit and has two autonomous and indivisible segments: Primary Market and Secondary Market.
In financial words, Stock Markets can also be defined as a procedure that permits people to trade in stocks and bonds, commodities, etc. which facilitates:
- Issue of new shares ( IPO)
- Raising of capital ( IPO, Bonds)
- Transfer of risk (Derivative market)
- Transfer of liquidity (Money markets)
- International trade (Currency markets)
In this article, we are going to discuss the primary and secondary market in order to under how stock market exactly works. Let’s get started.
1. Primary Market
The primary market is a market for new issues i.e. Market for fresh capital. It provides a sale for new securities. The primary market provides an opportunity to issuers of securities like government and corporations to raise resources to meet requirements of investment or, discharge some obligation.
The corporate entities mainly issue debt and equity instruments (shares, debentures) while the governments issue debt securities (treasury bills). The issues might be released at face value or, at a discount/ premium which later molds into various forms such as equity, debt, etc. However, these issues can be released in both domestic or, international markets.
The primary market issuance is either done through public issues or, private placement. When an insurance of securities is made to new investors for becoming part of shareholders’ family, it is called a public issue. The public issue can be further classified into:
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IPO takes place when an unlisted company makes either a fresh issue of securities. This flags off an avenue for listing and trading of the securities issued in the stock exchanges.
— Follow-on Public Offering (FPO):
An FPO takes place when an already listed company makes either a fresh issue of securities to the public or an offer for sale to the public, through an offer document.
When an issuer makes an issue of securities to a specific group of persons where the number of members should not be more than 49, it is called a private placement. However, it is neither a rights issue nor a public issue. Private Placement of shares by a listed issuer can be of two types:
— Preferential Allotment
When a listed issuer issues shares or convertible securities, to a selected group of persons in terms of provisions by a regulatory body, it is called a preferential allotment. The issuer is needed to adhere with diversified provisions which include disclosures, pricing, lock-in, etc.
— Qualified Institutional Placement (QIP)
When a listed issuer issues equity shares or, securities convertible into equity shares to Qualified Institutions Buyers only in terms of provisions of the regulatory body, it is known as Qualified Institutions Placement.
2. Secondary Market
The secondary market allows participants who clasp securities to acclimatize their holdings according to the changes in their evaluation of risks and returns. Once the new securities are issued in the primary market, they are traded in the stock ( secondary ) market up and onwards from the listing day. The listing of stock enables liquidity and earning of reputation.
The secondary market operates through two channels and they are Over-The-Counter (OTC) Market and the Exchange-Traded market.
OTC markets are informal in nature where the execution of trades has a negotiable option. Most of the government securities are in the OTC Market. In addition, all the spot trades where securities are traded for immediate delivery and payment also take place in the OTC market.
The other option is to trade using the infrastructure provided by the Stock Exchanges where financial instruments are dealt with in money transactions. The four important participants of the securities market are the investors, issuers, intermediaries, and regulators.
- Investors can be broadly classified into retail investors (HNI, minuscule investors) and institutional investors (banks, insurance, mutual funds, FII, etc).
- Issuers include governments,corporate,financial institutions, etcetera.
- Intermediaries include stock exchanges, stockbrokers, depository, custodians, merchant bankers, FII, mutual fund houses, debenture trustees, etc.
- Regulators include Central Banks.
Components of the Secondary Market:
The securities market is classified into the following markets and further different types of instruments are traded in these markets.
1. Cash /Equity Markets:
The equity segment allows dealing in shares, debentures, warrants, mutual funds, ETFs.
2. Equity Derivatives Market:
The derivatives segment allows trading in derivative instruments. It is a product whose value is derived from the value of one or more basic variables and is called bases ( underlying asset, index). The underlying asset can be equity, forex, commodity or, any other asset. There are two types of derivatives instruments (futures & options).
3. Debt Market:
The debt market consists of bond markets that provide financing through the issuance of bonds.
4. Corporate Bond Market:
Bonds issued by firms are Corporate bonds and are issued to meet needs for expansion, modernization, restructuring operations, mergers, and acquisitions.
5. Forex Market:
The foreign exchange market( currency, forex, or FX) is where currency trading takes place. Currently, the Forex market is one of the largest and most liquid financial markets in the world and includes trading between large banks, central banks, currency, speculators, corporations, governments, and other financial institutions.
6. Commodity Derivatives Market:
Commodity markets enable the exchange of raw or, primary products. Raw commodities are traded on standardized commodities exchange in which they are purchased and sold in well –defined contracts. The trading in gold, silver and agricultural goods are also facilitated under this market.
By now you must have got the idea of the primary market and secondary market. Let’s conclude what we discussed in this article.
The primary market, also known as New Issue Market (NIM), is the market place where new shares are issued and the public buys shares directly from the company, usually through an IPO or FPO.
On the other hand, the Secondary Market is the place where formerly issued securities are traded. The second market involves indirect purchasing and selling of shares among investors. Brokers are Intermediary and the investors/traders get the amount on the sale of shares.
That’s all for this post. I hope it was useful for you. Happy Investing.